Author Topic: returns and liquidity  (Read 2876 times)

sol

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returns and liquidity
« on: September 17, 2015, 07:18:59 PM »
A recent bloomberg piece made the case that comparing investment returns of alternative assets to the stock market is unfair, because very few other investments are as liquid or low-risk.  The author claims that if markets are "Close to efficient" then nobody beats the index without taking on either more risk or accepting reduced liquidity.

It occurred to me, reading that, that for most people here with a lifetime-long investment horizon, liquidity isn't so important.  Are there other investment types that can offer us better returns in exchange for reduced liquidity?  Is real estate the quintessential example of this trade off, or are there others I should be considering?

The risk/reward ratio is generally something you can control, by using leverage.  The liquidity/reward ratio seems harder to exploit.

Ricky

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Re: returns and liquidity
« Reply #1 on: September 17, 2015, 09:06:56 PM »
I'm not really sure I understand the intent of the article.

Risk/reward will always be correlated regardless of the factors that go into determining an investment's risk. Sure, liquidity, among other factors will determine the amount of risk. The return (percentage) is the apples to apples comparison that I think is always fair to make.

I don't see anything wrong with comparing the return one is getting from one investment to the returns of the S&P index or any other investment. Then again I don't see any point in it either. Everyone has different risk tolerances and will choose their investments accordingly.

brooklynguy

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Re: returns and liquidity
« Reply #2 on: September 17, 2015, 09:52:12 PM »
It occurred to me, reading that, that for most people here with a lifetime-long investment horizon, liquidity isn't so important. 

I'm not sure our indefinite investment horizon is anything special when it comes to illiquid investment vehicles like real estate.  The average person who purchases stock (which generates most of its return through capital appreciation, making liquidity critically important) may have a shorter weighted average expected investment horizon for their stock purchases than the average mustachian who does so, but I don't think the same is necessarily true with respect to real estate and other illiquid assets which generate returns primarily through income.  Does the average non-mustachian real estate investor (not counting speculators who purchase in the hope of exploiting price appreciation) really have a less-than-lifetime-long investment horizon?

NorCal

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Re: returns and liquidity
« Reply #3 on: September 17, 2015, 10:10:40 PM »
The article was pretty spot-on conceptually, but missed tons of details and supporting research.  It looks like the author literally took a finance 101 textbook and summarized three chapters in one page.

In practice, liquidity doesn't matter on a day to day basis.  But when it matters, it REALLY matters.

Just like your normal risk-premiums for inflation risk, return risk, volatility risk, etc etc, there is a liquidity risk premium.  That is, how much added return do you get from holding illiquid assets?  Depending on the situation, it can be significant.  Or it can be nothing.

If you think of a residential real estate investment, you can earn outsized returns if you are able to buy from people that need to sell immediately.  On the flip side, you get screwed when you're the one who has to sell immediately.  If you are buying, holding, and eventually selling without any distressed sales involved, your returns from the liquidity risk premium will be negligible (assuming no changes to the underlying market premium).

Back when I worked in venture capital (many years ago), the liquidity risk premium on stocks was roughly 50%.  That is, a public stock would trade at ~50% premium to private stocks.  Now that Silicon Valley has gone bonkers again, some of the big name startups actually have a negative liquidity risk premium.  Their private market price is higher than their public market price would be. 

arebelspy

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Re: returns and liquidity
« Reply #4 on: November 02, 2015, 04:41:31 AM »
A recent bloomberg piece made the case that comparing investment returns of alternative assets to the stock market is unfair, because very few other investments are as liquid or low-risk.

More relevant to me than the low liquidity is the extra work RE takes; that's why it's harder to compare returns.  Equities can be totally passive (any work needed is decided by you, i.e. trading based on momentum, rebalancing, etc., and even a lot of that can be automated or done for you).
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DaveR

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Re: returns and liquidity
« Reply #5 on: November 02, 2015, 01:45:39 PM »
It occurred to me, reading that, that for most people here with a lifetime-long investment horizon, liquidity isn't so important.  Are there other investment types that can offer us better returns in exchange for reduced liquidity?  Is real estate the quintessential example of this trade off, or are there others I should be considering?

Some assets less liquid than large cap stocks: real estate, private equity, penny stocks, peer-to-peer loans, art/collectibles... there are lots of ways to chase yield.

As NorCal points out, the key to liquidity risk is timing: buy distressed assets...wait...sell when in demand. Smells like market timing to me. Hopefully the "wait" piece generates cash flow and market inefficiencies (transaction costs) don't wipe out all profits.

mr_orange

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Re: returns and liquidity
« Reply #6 on: November 12, 2015, 06:34:12 AM »
Good discussion. 

Yes, real estate or any other illiquid asset can be exploited easier and thus you can get substantial discounts to fair market value because it is not traded as easily.  Real estate also has the advantage that there is a large cartel that keeps transaction costs high and thus creates additional friction from trades. 

There are certainly other less than efficient markets that have similar characteristics (viatical purchases, inventory financing, minority LP interests, etc.).  To Arebelspy's point above many of these investments require specialized knowledge and thus have a time component baked into purchasing them.  Some would claim you need to account for all of the time spent developing the skillsets and sourcing the assets when you compare them with stock market returns.  This sort of argument necessarily relies on assumptions about what resources you have at your disposal.  Accounting for your time makes a lot of sense if you have a giant stack of capital and little spare time.  If, however, you have spare time and very little capital that you need to make work harder your decision matrix may be different.  Everyone needs to evaluate for themselves how they choose to invest their time and what value seeking additional yield has to them. 

There is nothing wrong with holding assets forever.  That is what many of the most wealthy real estate investors I know do.  When they do "sell" they exchange the asset and avoid capital gains taxation or recapture taxes.  They also use paper expenses from the larger trades to shield parts of their income and reduce their overall tax burden.  We paid around 17% effective taxes last year on close to $300k in income; not bad. 

tonysemail

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Re: returns and liquidity
« Reply #7 on: November 12, 2015, 02:08:50 PM »
the first thing that came to mind was timberland investment and I see this topic has been well dissected in several posts-
http://forum.mrmoneymustache.com/investor-alley/timber-investing-for-a-mustachian/
http://forum.mrmoneymustache.com/investor-alley/a-true-non-market-correlated-long-term-nvestment-forestry/
from what I gather, several forum members have contemplated this and it's harder than it seems.

I don't really agree that liquidity is unimportant to mustachians.
most of us need to live off the 4% and therefore prize the liquidity of the stock market.

brooklynguy

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Re: returns and liquidity
« Reply #8 on: December 09, 2015, 02:15:40 PM »